The first article on this issue (Part 1) focused on INFO 271[1] to develop archetypal cases that the Australian Securities and Investments Commission (ASIC) might pursue. This article is Part 2. It will focus on cases that might arise outside of INFO 271, such as portfolio management practices and controls, inflated returns, and proxies. Part 3 will focus on cases arising from prospectuses and product disclosure statements.
Portfolio Management Practices and Controls
The US regulator, the Securities and Investments Commission (the SEC), released a Risk Alert on 9 April 2021.[2] In the Risk Alert, the SEC highlighted “internal control weaknesses”[3] as a “risk area” (amongst others). These weaknesses manifested through the absence of any, or any adequate, policies and procedures:
- to ensure that actual firm practices were consistent with ESG disclosures made by the firm. For example, contrary to statements in marketing materials the firms did not adhere to ESG frameworks or publicised strategies to only invest in companies with high ESG scores;
- around implementation, monitoring and updating of clients’ negative screens (e.g., prohibitions on investments in the “sin-stocks” viz. alcohol, tobacco and firearms); and
- on the firm’s ESG investing analyses and processes, decision making processes or compliance review and oversight.
The SEC’s proceeding against Pax World Management Corp (discussed in Part 1), illustrates how “internal control weaknesses” can lead to regulatory investigations and enforcement action for what in effect amounts to “greenwashing”. Pax is a registered investment adviser and provides investment advisory services to four Funds[4] in the USA. The Funds offered socially responsible investment products, which employed a negative screen that excluded “sin-stocks” (the SRI Restrictions). Pax breached the SRI Restrictions by purchasing several “sin-stocks” it either did not screen or failed to satisfy the SRI Restrictions. Pax had represented in its Annual Report that its Social Research Department regularly scheduled reviews of all the Funds’ holdings. This did not occur, and further Pax had no formal policy or procedure for the continuous monitoring of portfolios for compliance with the SRI Restrictions.
Further, under the SRI Restrictions, Pax had to divest within 6 months any securities that fell out of compliance with the SRI Restrictions. Pax did not have in place systems to ensure this occurred.
The result of the “internal control weaknesses” was administrative and cease and desist proceedings against Pax for materially misleading statements[5] and a civil penalty of $500,000.[6]
Inflated Returns
In its recent surveillance[7] of the marketing of managed funds’ performance and risk, ASIC identified several concerns including that targeted returns were presented without warnings or sufficiently prominent warnings[8]. These findings do not appear to have been in relation to ESG or sustainability related funds. Interestingly, ASIC stated these findings did not amount to a “breach of the law.” [9]
In the US, the SEC has identified that the returns of “ESG oriented funds” have been artificially inflated by incorporating non-disclosed “expense reimbursements” from fund sponsors to fund managers. This conduct is potentially misleading or deceptive under the statutory provisions[10] because retail investors are potentially misled into investing in “ESG oriented funds” that are advertised as having “favourable risk, return and correlation metrics” where those “returns” are not generated from the core performance of the funds per se.
Proxy
In the following hypothetical example, RE Ltd is the responsible entity for several investment funds that hold shares in Oil Ltd. Three shareholder ESG resolutions were proposed (the ESG proposals) at Oil Ltd’s annual general meeting:
- disclosing information about the managing down of oil operations and assets;
- the cessation of all lobbying activities for the development of new oil fields; and
- disclosing information on the decommissioning of assets under various climate scenarios.
RE Ltd acknowledged:
- there was insufficient evidence to support Oil Ltd’s claims of alignment with the Paris Agreement and Glasgow Climate Pact goals;
- it did not accept Oil Ltd’s rationale for not disclosing its Scope 3 emissions targets; and
- the lack of targets, limits shareholders’ ability to understand and price the climate risk.
Despite these acknowledgements, RE Ltd ultimately did not cast its proxy votes in support of the ESG proposals because it considered the proposals were too prescriptive.
The above example raises several issues that might attract regulatory investigation and enforcement action for greenwashing.
Firstly, if RE Ltd’s proxy voting guidelines represented the voting of proxies in favour of the ESG proposals that could give rise to a greenwashing risk. But such a case is not without difficulty. Usually, proxy voting guidelines are expressed generally (rather than prescriptively) and provide latitude to the proxy holder:
- to undertake a case by case analysis; and
- to support management and the Board in determining an appropriate strategy for the company and shareholders.
However, that might not be the end of the greenwashing risk. In the Risk Alert, the SEC highlighted as a risk area differences between the disclosed proxy voting policy and the actual proxy voting process[11], namely:
- public statements that ESG related proxy proposals would be independently evaluated internally on a case by case basis to maximise value, while the internal guidelines did not provide for such a case by case analysis; and
- clients were never provided an opportunity to vote separately on ESG related proxy proposals despite public claims to the contrary.
Second, if RE Ltd had loaned some of the portfolio shares to borrowers in return for cash or other shares (share-lending), the voting rights attached to the loaned shares are transferred to the borrower. Recently, the SEC expressed concern that with share-lending, fund managers are: [12]
- trading away their voting rights on sustainability issues; and
- not recalling the loaned shares prior to shareholder meetings, where sustainability issues are on the agenda.
These practices if inconsistent with ESG disclosures and marketing materials could give rise to a greenwashing risk under Australian jurisprudence.
Third, if RE Ltd had engaged a proxy advisory service (e.g., Institutional Shareholder Services or Glass, Lewis & Co.) to provide a report recommending voting on company resolutions[13], a greenwashing risk could arise were RE Ltd to adopt recommendations that do not align with RE Ltd’s ESG objectives and proxy voting policy.
In 2017-2018, ASIC published several reports in which it examined (broadly) the relationship between proxy advisers and companies. [14] Interestingly, ASIC reported that “empirical data reviewed…in relation to the 2017 AGM season appears to suggest that concerns regarding the extent of influence of proxy adviser recommendations on the voting outcomes of company resolutions is overstated”.[15] Despite this, in April 2021 the Federal government announced that it would embark on a consultation process on the transparency and accountability of proxy advice. This led to the proposal of regulations[16] to amend the Corporations Regulations 2001 (Cth) and the Superannuation Industry (Supervision) Regulation 1994 (Cth) to strengthen the transparency and oversight of proxy advice. Ultimately, the proposed regulations were tabled but disallowed on 8 February 2022.
Concerns in relation to proxy advisers’ recommendations may come into renewed focus as the regulatory oversight of sustainability related financial products continues to intensify. This might bring into play the obligations of honesty and fairness in relation to financial services covered by the proxy advisers’ Australian Financial Services Licences[17] and the misleading and deceptive conduct provisions.[18]
[1] INFO 271 (How to avoid greenwashing when offering or promoting sustainability-related products)
[2] SEC’s Risk Alert entitled “The Division of Examinations’ Review of ESG Investing” dated 9 April 2021 at p.2
[3] ibid.
[4] Pax World Balanced Fund ($1.9 billion in assets under management), Pax World Growth Fund ($100 million in assets under management), Pax World High Yield Fund ($70 million in assets under management) and Pax World Money Fund
[5] Sections 203(e) and (k) of the Investment Advisers Act 1940; and sections 9(b) and (f) of the Investment Company Act 1940.
[6] In the matter of Pax World Management Corp., before the Securities and Exchange Commission (Administrative Proceeding File 3-13107). Florence E. Harmon (Acting Secretary).
[7] ASIC’s Media Release, 22-249MR “Managed funds amend their marketing following ASIC surveillance” dated 8 September 2022
[8] ibid.
[9] ibid.
[10] Sections 769C, 1041E, 1041F, 1041H of the Corporations Act 2001 (Cth). Sections 12BB, 12DA, 12DB, 12DC, 12DF and 12DG of the Australian Securities and Investments Commission Act 2001 (Cth). Regulatory Guides 65, 168 and 234 provide further guidance.
[11] SEC’s Risk Alert entitled “The Division of Examinations’ Review of ESG Investing” dated 9 April 2021 at p.2
[12] “SEC Broadens Probe into ESG Funds: Report” by Ron Day. Yahoo Finance, 17 August 2022.
[13] Report 578 (ASIC review of proxy adviser engagement practices) June 2018 at p.4
[14] Report 539 (ASIC regulation of corporate finance: January to June 2017); Report 564 (Annual general meeting season 2017); and Report 578 (ASIC review of proxy adviser engagement practices) June 2018
[15] Report 578 (ASIC review of proxy adviser engagement practices) June 2018 at p.4
[16] Treasury Laws Amendment (Greater Transparency of Proxy Advice) Regulations 2021 (Cth)
[17] s.912A(1)(a) of the Corporations Act 2001 (Cth)
[18] For example, s.1041H of the Corporations Act 2001 (Cth)